“Inflation is taxation without legislation”  – Milton Friedman

Inflation may provide some benefit to society as a whole, but it also ravages many parts of that same society. Over time, sustained inflation will eat away the foundation of a strong economic system. The US has experienced sustained inflation for approximately the past 60 years. This is the longest sustained period of inflation in the history of the United States. While we don’t know what the future holds, other countries such as Japan may provide some hint of things to come. The Innovative Advisory Group Inflation Monitor, which we will be releasing next week, will briefly discuss Japan and what can happen after inflation subsides.

Regardless of what happens in the future with inflation in the US, it is important to consider how it will affect your investment portfolio. While I discussed how a hypothetical dividend stock could help you compound the growth of your family’s wealth in the first three parts of this series, I have not mentioned how the effects of inflation can eat away at this performance. This fourth article in the series will discuss both how inflation affects your investments, and how to use dividend stocks to beat inflation. This inflation beating secret could help you minimize the effects of inflation through another form of compounding or super-compounding.

Inflation – How it affects you and why you should be concerned

Inflation is a silent tax on a person’s wealth. It slowly erodes the purchasing power of a person’s cash. Let’s say you have $100 in cash today. It can buy $100 in chocolate at the store. If inflation is currently at 3% annually, then next year your $100 will be worth $97 in purchasing power. This means that while you still have $100, the same amount of chocolate you bought last year for $100 will be priced at $103 in the following year. The number of dollars you have has not changed, but the price of the chocolate you want to purchase with that $100 has gone up in price. Hence the value of your dollar has declined in comparison to that chocolate. Here is a chart of the effects of inflation on the US dollar in the past 100 years. This chart shows what a dollar from 1913 could buy you today.

A dollar from 1913 is now worth pennies on the dollar

The existence of persistent inflation eventually causes people’s behavior to change. A persistent slow rate of inflation eventually forces people to take risks with their wealth in order to not lose their purchasing power over time. This is why people invest in stocks, bonds, and other investments instead of keeping their wealth in cash. Conservative investors who hope to get 5% interest from a bank CD, are not taking a lot of risks, as long as the bank carries insurance for its deposits. However, that person is also most likely keeping pace with the rate of inflation, and not exceeding it. Of course, this rate usually doesn’t account for taxes, but that is the subject of another issue.